30 Jan, 2012 at 10:36 | Posted in Economics | Comments Off on Why anti-stimulus arguments do not apply

Simon Wren-Lewis tells us the main reason why – they ignore the zero lower bound for interest rates:

There are good arguments for saying that if monetary policy is free to do its job, then countercyclical fiscal policy is both unnecessary and welfare reducing. I have written on the subject. But having written those papers, I could see immediately the importance of that proviso about monetary policy. At the zero lower bound for interest rates (in a liquidity trap), monetary policy is clearly not free to do its job, and so different conclusions apply. See Eggertson and Woodford (2004). If the argument assumes that, despite the zero bound, monetary policy can do all that is required, then this should be said so explicitly, because it is somewhat counterfactual.

For exactly the same reasons, these arguments against countercyclical fiscal policy do not apply to individual countries in a monetary union. If monetary policy is set by the ECB, it cannot ensure output is at its natural level (‘full employment’) in each individual Eurozone country. There is a large literature on this, which I have contributed to, but a standard reference would be Gali and Monacelli (2008). There, as in most of this literature, countercyclical fiscal policy in the face of country specific shocks is welfare improving.

Simon Wren-Lewis – economics professor at Oxford University – gets it basically right on the counterfinality of solving the euro crisis with austerity measures:

We can put it this way. If the problem is simply one of government debt, and we have good reason to believe there is too much debt in most Eurozone countries (including Germany), then general austerity is the order of the day. Whereas the markets believe Germany will undertake austerity of their own free will, in other countries neither the markets nor the ECB believe this, so we need a continuing but controlled crisis to force these countries to act. However, if the problem is external imbalances and competitiveness, we have a danger of ‘competitive austerity’. We need more austerity outside Germany than within Germany to correct imbalances between the two. The more Germany adopts a contractionary fiscal policy the further countries outside Germany are forced to go. The end result is not only general stagnation within the Eurozone, but recession so acute in some countries that political turmoil may follow, possibly leading to the breakup of the Eurozone.

In other circumstances, competitive austerity might not be a problem, because the ECB could counteract any general stagnation by reducing interest rates. There are two reasons why this is not a way out today. First, by raising interest rates last year, the ECB appears to be too preoccupied by short term inflation, so they may not act when they should. Second, and more fundamentally, they are close to a zero lower bound, and so have lost the ability to prevent a second recession through monetary policy. So unlike the case where the problem is risk premia on government debt, the ECB cannot be sure to act effectively in a Eurozone recession.

This suggests that the key problem for the Eurozone is similar to that faced by the US, the UK and others. Too much austerity in the short term is holding back or even killing the recovery from the last recession, because monetary policy has lost its power in a liquidity trap. In these other countries this excessive austerity will ‘only’ result in significantly higher unemployment for many years to come. In the Eurozone the consequences could be more dramatic.

Stumbling and mumbling – Chris Dillow – has a thought-provoking piece on the austerity policies so often pursued nowadays by governments in Europe:

Macroeconomic policy, then, is not only made by rank amateurs – not one of the five Treasury ministers in the Commons has a postgraduate qualification in economics and only one has significant experience in financial work. It is made by amateurs who seem immune to feedback. Errors are only to be expected.

Which raises a paradox. The job of running the economy is entrusted to anyone. But the job of running companies requires people of such rare and delicate talent that only multi-million salaries will attract and motivate them.

Why the inconsistency? I suppose you could argue – Robert Lucas style (pdf) – that the benefits of good macroeconomic stabilization policy are small, as are the costs of bad policy, so it doesn‘t matter much who runs macro policy …

An alternative argument is that fiscal policy is not meant to be competent, but is instead meant to reflect the preferences of voters, and democracy is an intrinsic good, not an instrumental one.

There is, though, a third possibility. The purpose of macroeconomic policy is not to stabilize the economy or to raise growth, but is instead merely an ideological cover for shrinking the state. And that justification for multi-million salaries is merely ideological cover for kleptocracy. It’s just class war.

Actually, I understand why; the inflation hawks are still a powerful force that must be appeased. But the truth is that recent experience has made an overwhelming case for the proposition that the 2 percent or so implicit target prior to the Great Recession was too low, that 4 or 5 percent would be much better. Even the chief economist at the IMF says so …

The thing is, if we’re going to lock in a formal inflation target, now would be a good time to get it right, instead of waiting until the memory of the crisis fades and everyone gets complacent again.

25 Jan, 2012 at 23:57 | Posted in Theory of Science & Methodology | Comments Off on Why economists should focus more on mechanisms and less on deductive-axiomatic models

Stumbling and mumbling – Chris Dillow – has a nice piece on why people interested in real economies ought to focus on mechanisms rather than models of the deductive-axiomatic ilk:

Simon Wren-Lewis asks a good question about Robert Lucas‘s and John Cochrane‘s apparent misunderstanding of the balanced budget multiplier: how can very clever people make silly errors?

He suggests two good answers. I’d like to suggest a third. There are two different ways of thinking about economics – the model paradigm and the mechanism paradigm, and the former has crowded out the latter.

Simon says:

If you spend X at time t to build a bridge, aggregate demand increases by X at time t. If you raise taxes by X at time t, consumers will smooth this effect over time, so their spending at time t will fall by much less than X. Put the two together and aggregate demand rises.

This is clear and true. And it would be obvious to anyone using the mechanism paradigm. If you ask “What is the mechanism whereby higher taxes reduce consumer spending?” you pretty much walk into the notion of consumption smoothing. Equally, though, the paradigm also leads one to other reasons to be sceptical of the practical efficacy of the balanced budget multiplier.

But lots of brilliant economists don’t think merely in terms of mechanisms but rather build impressive models. And like photographers, they tend to fall in love with their models which distracts them both from others’ models and from mechanisms.

…

A good example of this lies in the idea of expansionary fiscal contraction. The virtue of this idea is that it draws our attention to mechanisms (a falling exchange rate, better corporate animal spirits, whatever) whereby fiscal contraction might boost the economy. The drawback is that these mechanisms are just unlikely to operate here and now. Yes, there’s a model that tells us that expansionary fiscal contraction can work. And there are models that say it can’t. But arguing about competing models misses the practical point.

Now, there is an obvious reply to all this. Models have the virtue of ensuring internal consistency, and thus avoiding potentially misleading partial analysis. However, I’m not sure whether this is an argument against mechanisms so much as against poor thinking about them.

Comments Policy

I like comments. Follow netiquette. Comments — especially anonymous ones — with pseudo argumentations, abusive language or irrelevant links will not be posted. And please remember — being a full-time professor leaves only limited time to respond to comments.